SINGAPORE (Reuters) - Major Western banks may have to scale back or even withdraw from some of Asia's developing financial derivative markets due to regulatory hurdles and rising costs.
Under new global regulations, banks must put their trades in commonly traded, over-the-counter derivatives such as interest rate swaps through central clearing houses.
The problem lies with the rules at new clearing houses in India, China and South Korea, which risk making it prohibitively expensive or even impossible for some foreign banks to trade derivatives in these countries.
For instance, members of India's clearing house, the CCIL, are concerned they could be exposed to unlimited liability should one or more participants default.
Another big sticking point is whether the CCIL, along with China and South Korea's planned new derivative clearing venues - the Shanghai Clearing House and Korean Exchange (KRX) - will meet the standards for clearing houses set by the global markets supervisory body IOSCO and the central banker's Committee on Payment and Settlement Systems (CPSS).
The principles look set to clash with those countries' domestic laws on bankruptcy, meaning it will be more expensive for banks to trade there.
Understandably, foreign banks are reviewing the costs of staying in these markets.
"The CPSS-IOSCO compliance issues come down to cost as banks can still clear at non-compliant CCPs, only that they will face much higher regulatory capital charges," said Keith Noyes, Asia-Pacific regional director for the International Swaps and Derivatives Association (ISDA).
"Individual banks will do the math and decide if it's worth their while continuing to do business in those markets at those CCPs (central ccounterparties)."
India has a Oct 1 deadline for mandatory clearing of rupee forwards. Over the course of the next year, many other over-the-counter derivatives in Asia will have to be centrally cleared, too, as countries bring in new legislation.
That means international banks, currently in negotiations with the new clearing houses, could pull back from trading products such as rupee forwards or won-denominated swaps. Liquidity would be hit as local banks find their regular foreign counterparties unwilling to trade or roll over positions.
While Asian banks may gain some market share as a result, concerns are growing that such a pullback by European and U.S. players could drain liquidity from these markets, even as policymakers and companies grapple with the stresses produced by the global economic slowdown and volatile financial markets.
"Liquidity could dry up, so it's a big concern. There could be a downstream affect as well, swaps trades tend to be hedged with futures, so it could hurt futures as well," said Bill Herder, executive director for the Futures Industry Association in Asia.
"These are fast growing markets, but for them to grow further they need external liquidity," he added.
The derivative markets in India, China and South Korea are still tiny compared to those in the United States and Europe, but have all more than quadrupled in size since 2004.
Figures from the Bank for International Settlements (BIS) show that the average daily turnover in interest rate derivatives in these markets in April 2010 was $1.5 billion in China, $3.5 billion in India and $10.7 billion in South Korea.
All three countries are establishing new central clearing houses to meet their G20 commitments to make over-the-counter (OTC) derivatives markets more transparent and less risky to the wider financial system. The G20 wants derivative trades in products such as interest rate swaps to be centrally cleared so that the credit risk of a bank defaulting on a trade is shared between members of a clearing house.
Unlike Singapore and Hong Kong, India, South Korea and China plan to force commonly-traded OTC derivatives to be cleared onshore at their domestic clearing houses rather than allowing them to go through a larger offshore clearer such as LCH-Clearnet or CME.
The first hurdle for foreign banks is whether their home regulators will even let them join these clearing houses.
American regulators are unlikely to let U.S. banks join clearing houses if there is no cap on the degree of liability they would face in the event of multiple defaults.
European banks report that it is still uncertain how or when their regulators will decide which Asian clearing houses are appropriate for them to use.
"U.S. and European regulations have the potential to prevent their country's banks from clearing at third country CCPs (central counterparties) that do not conform to their regulatory prescription," said ISDA's Noyes.
Still, there is optimism most of these entry hurdles can be overcome.
"We have reached an agreement of what are the changes that are needed to be made and those are acceptable to the foreign banks. We are waiting for the Reserve Bank of India's acceptance," said Indirani Rao, the chief forex officer at CCIL.
An official for KRX, who asked not to be identified, said it hoped Asian governments would work together with their western counterparts to find a resolution.
"The objective of the CCP is to maintain stability in the financial system, so I don't think unilateral actions will be appropriate," he said.
"I understand that there are some discussions over the matter at the government-to-government level, and I think there will be some adjustments between various parties."
However, the CPSS-IOSCO principles present another hurdle.
The standards have just been toughened up in order to reflect the systemically important role central clearing houses will play now they are set to clear trillions of dollars of OTC derivatives every day.
But lawyers say that at present, local laws in these countries clash with some of the principles on insolvency and netting, the ability of banks to offset trades.
That won't prevent banks from joining these clearing houses, but it will mean trades cleared there will not be eligible for any capital relief under Basel III.
Basel III had aimed to give banks an incentive to use clearing houses by allowing them to set aside less capital for trades that are centrally cleared than those that aren't.
"The Asian central clearing houses have a deepening understanding of the issues, but there is still much work to be done to ensure that the hurdles are removed and international banks continue to be effective in providing liquidity to on-shore markets," said Peter Connor, head of markets clearing for Asia Pacific at Deutsche Bank.
A clearing executive at one global bank said that while it will likely sign up as a member with most of the new clearing houses, the move would be "ceremonial" rather then indicative of plans to put much business through them.
Any pullback by Western banks could play into the hands of local Asian banks, who will not face the same regulatory constraints, although they are unlikely to make up for the liquidity shortfall.
"It's my view that the local banks with the strong deposit bases and good capital structures are in a position to benefit from increasing regulatory capital charges," said ISDA's Noyes.
Additional reporting by Vidya Ranganathan in SINGAPORE, Suvashree Dey Choudhury in MUMBAI, and Se Young Lee in SEOUL; Editing by Kim Coghill